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Target funds sometimes called life cycle funds became popular in the late '90s as a way to provide good diversification and subsequently higher returns with a minimum of hassle and time on your part. And now with last year's newly enacted Pension Protection Act (PPA), employers have an even greater incentive to offer target funds in employee retirement plans and the popularity is growing. Target funds consist of a single investment in a mix of stock and bond funds that can instantly diversify your investments and depending on your age, the mix will change over time, becoming more conservative as you get older. Some use a fixed mix say 60 percent bonds and 40 percent stocks that are suitable if you are nearing retirement. Several investment companies create these target funds by using their own family of funds –a fund of funds. Sounds great doesn't it? All you have to do is keep investing in your 401(k) and let the money manager of the fund make the detailed investment and diversification decisions for you. If you don't have much experience investing and don't have the time or inclination to monitor the performance of the fund, it may be a good choice. But you should also be aware that there are some disadvantages to target funds that you really should know about. Target funds can be very complicated to understand. So complicated that even a math professor would get confused. Some mutual fund companies retain as many as 40 advisory firms for each target portfolio while others use over 30 different mutual funds in the Target fund to provide diversification and because of the large overlap between the different funds there is super diversification, which can produce much poorer results when compared to a well diversified portfolio. Target funds can be very expensive. There is also a wide disparity in the investment costs associated with these funds. Since many of them are essentially a fund of funds expenses can be high. Typically expense ratios vary from as low as 0.2 percent to as high as 2.5 percent plus another 1.0 to 1.5 percent redemption fee. If your retirement plan contains these high priced target funds (anything over 1.0 percent or so) consider using lower cost index funds to create your own "mix." Hefty expenses over time can be a significant "drag" on performance. Using your retirement date may not be the best approach. Depending on your retirement plans, age, health and personal situation you may very well want to keep a more aggressive mix well past you official retirement date. A retirement plan that analyzes all your resources including after tax and IRA accounts as well as your retirement pension benefits along with social security benefits should be part of your overall strategy. The more complicated the target fund's holdings are and the more flexible the asset mix used, the more difficult this task becomes over time. Target funds can provide you with reasonable diversification and reduce the time you will need to devote to your finances, but you need to realize these are not buy and forget investments. Over time as the competition heats up and profit margins erode, these funds will change everything from their investment philosophy to expense structure and ultimately the fund may become unsuitable for you.
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